IRS audits of small business software files
Practitioners should balance risk for their clients.
Tax practitioners have always been cautious with the records they provide to the IRS in an audit to control the depth of an IRS inquiry. But IRS agents are starting to request client backup files from small business accounting software such as QuickBooks and Peachtree, and many practitioners are concerned about how much information the IRS is requesting and how it is using that information.
This article explores the IRS’ legal authority and long-standing use of electronic records in audits and takes a closer look into how the IRS requests and uses electronic files. It offers tips for CPA practitioners in responding to IRS requests for small business accounting files and for their clients in adjusting bookkeeping practices to minimize undue IRS inquiry during a small business audit.
In October 2010, partially at the request of tax practitioners during IRS focus groups, the IRS announced it was expanding its audit capabilities by training agents to be proficient in auditing information from files of accounting software commonly used by small businesses. According to the IRS, it has trained 1,100 revenue agents and has given them copies of the software to become proficient in using them and other programs in the future. It also encouraged agents to start requesting electronic files from taxpayers and practitioners. According to the IRS, the push to start using small business accounting files in audits originated with feedback from tax practitioners in 2008 focus groups. Practitioners indicated they wanted the IRS to be more efficient in examining records and reduce the volume of paper involved in audits. The IRS saw this as making audits more efficient for its agents as well.
IRS AUTHORITY TO REQUEST ELECTRONIC RECORDS
It’s clear in IRS regulations and precedent that electronic records can be requested and used in audits. Sec. 6001, Regs. Sec. 1.6001-1(a), Rev. Rul. 71-20 and Rev. Proc. 98-25 give the IRS broad authority to examine electronic records to establish the taxpayer’s correct tax liability. Regs. Sec. 1.6001-1(e) requires the taxpayer to make these records “at all times available for inspection by authorized internal revenue officers or employees, and shall be retained so long as the contents thereof may become material in the administration of any internal revenue law.” Rev. Proc. 98-25 clarified that the IRS has a right to electronic records.
The taxpayer must provide the electronic records upon request. If a taxpayer attempts to withhold them, the IRS may disallow all of the items that are unsubstantiated as a result of the decision to withhold the files—or it may summon the records.
SUMMONS POWER UPHELD
In June, the IRS prevailed in a summons enforcement case in U.S. District Court (Rouse, No. 8:11-MC-00046-T-24AEP (M.D. Fla. 6/27/11)). The IRS had requested the taxpayer’s QuickBooks backup files. The taxpayer refused to comply, and the IRS enforced the summons. The judge in the case summarily ordered the taxpayer to turn over the records to the IRS, citing Secs. 6001 (records required) and 7602(a) (IRS summons authority), and concluding the IRS had met the good-faith requirements for enforcing the summons under Powell, 379 U.S. 48 (1964). However, many facts of the case remain unclear, including whether the taxpayer offered alternative records to the IRS in lieu of the electronic files. In its decision, the Rouse court reiterated the right of the IRS to have original books and records: “A plain reading of § 7602 reveals that the I.R.S. may ‘examine books, papers, records, or other data which may be relevant or material to such inquiry …’ 26 U.S.C. § 7602(a)(1) (1998) (emphasis added). The Court finds that ‘other data’ under § 7602 includes the electronic backup files at issue, and thus, the summons is appropriate.”
IRS GUIDANCE
Although the courts are helping define this emerging issue, the IRS clearly has the largest stake in guiding agents and tax practitioners in how to comply. On Sept. 1, the IRS Small Business/Self-Employed (SB/SE) division issued a field directive memo (SBSE-04-0911-086) for agents and auditors about how to request, review and protect taxpayer backup files. It also updated a set of frequently asked questions (FAQs) at tinyurl.com/68gt5kb.
The memo instructs examiners to generally request a copy of the taxpayer’s original software backup file but to use professional judgment when determining which records to request. For example, agents would likely request files in larger-scope audits (such as when verifying gross income), but they probably wouldn’t request files in an audit of one expense item, according to the FAQs.
The IRS memo instructs agents to limit their review to information relevant to the year under examination. However, if the IRS is examining certain issues, such as accrual accounting or reconstruction of income, then it might review relevant data from other tax periods, according to the FAQs. Based on the results of an examination, the IRS also might expand the scope of an audit. In that case, the IRS would notify the taxpayer and use the available records. These updates leave room for IRS agents to determine when to examine prior- and subsequent-year data.
The IRS also mentioned that agents would not use the files for any purposes other than the examination and that the information is not disclosable to the public. The IRS stated that, if the file has “privileged information,” such as information protected under the Health Insurance Portability and Accountability Act of 1996, the representative should speak to the IRS agent about redaction. At this point, it appears that the IRS will not endorse any redaction. However, a discussion with the agent might be warranted to determine what could be redacted.
WHAT REVENUE AGENTS ARE LOOKING FOR
IRS auditors prefer reviewing and assessing the original books of entry—not translated or interpreted versions—to evaluate audit trails and the reliability of records.
Audit trails are critical in IRS examinations. The auditor can view dated transactions, subsequent changes, and the user name of the person who entered or changed a transaction. This information is directly relevant to the evaluation of the taxpayer’s accounting system and internal controls.
On May 27, the IRS modified its Internal Revenue Manual (IRM) to provide guidance and rules on how revenue agents should evaluate taxpayers’ electronic books and records. The IRS description of electronic books and records also includes taxpayer websites, e-commerce activities and Web marketing material, which the IRS finds useful for audit trails in tracing income, such as e-payments.
Some practitioners are concerned that taxpayer adjustments in business software files may raise red flags with the IRS unnecessarily, requiring more time and expense to explain them. They are concerned that the IRS will jump to conclusions by perceiving corrections of bookkeeping errors as attempts to manipulate books and records.
Practitioners face a dilemma. They want to supply the agent with the information needed, but many are concerned about turning over the entire backup file to the IRS.
FILE REDACTION
The IRS has commented publicly about taxpayers’ providing redacted prior-year files. On April 20, Chris Wagner, chief of the IRS Office of Appeals, addressed the redaction issue in a letter to the AICPA. In the letter (available at tinyurl.com/3rza5h6), Wagner confirmed the long-standing position of the IRS to have original documentation in an audit:
[I]t is important an exact copy of the original electronic data file be provided to the examiner and not an altered version. Only an exact copy of the original file includes the unaltered metadata which allows examiners to properly consider the integrity and veracity of the electronic files through use of such means as reports generated by the software program that may help to identify deleted or altered entries.
Wagner said that it’s acceptable for practitioners to “condense” prior-year information “as long as the condensed data does not include transactions created or changed for time periods under audit, or for transactions from prior years that have an effect on the years under audit.” The IRS published its approval of this position in its FAQs, where the Service also pointed out that, if the audit scope is expanded, the agent might request a backup file created before the file was condensed or a copy of the archive file created during the condensing process.
Wagner also noted a software limitation best solved by software companies—allowing single-year files in the backup process. Wagner suggested that, before a long-term solution is found, taxpayers should consider making their own backup files for individual years.
The AICPA hosted a meeting Sept. 8, with IRS officials and software developers about ways to minimize the amount of electronic data provided to the IRS during an audit. The AICPA discussed the need for software changes that would enable small business taxpayers to provide only information that is directly relevant to an IRS audit.
On Sept. 1, the IRS director, examination, provided guidance on requesting backup files when taxpayers or practitioners assert they cannot comply because the backup file contains privileged communications. The memo (SBSE-04-0911-086) suggests in either case examiners contact their local IRS counsel for assistance. “Generally, a customer list would not be privileged but there may be unusual circumstances in a particular case that could possibly make the information, when combined with other information, privileged,” the memo stated.
Danny Snow, CPA, immediate past chair of the AICPA IRS Practice & Procedures Committee, is interested to see how the IRS will approach the issue of redacted files. “We are aware that CPAs are providing selective data,” he said. “We are waiting to see if the Service challenges the altered files because critical audit trails may be deleted when providing the selective data.” Snow said that the IRS has used restraint so far and that the new SB/SE commissioner, Faris Fink, appears to want to work closely with the AICPA on this issue.
THE IRS IN TRAINING
For most IRS revenue agents, using electronic records in small business audits is a relatively new approach, becoming increasingly prevalent since October 2010. The IRS has more than 14,000 agents, and only 1,100 have been trained in the use of QuickBooks and Peachtree. Clearly, this IRS audit technique is in its infancy. There’s evidence in current audits that the IRS is still learning how to use these electronic files and, as a result, has not established a standard operating procedure.
An IRS representative at the IRS Tax Forum Aug. 16–18 in Las Vegas commented on IRS procedure for requesting and reviewing electronic files in audits. In a seminar titled “Auditing with Electronic Accounting Software,” the representative detailed how the IRS requests records and how they should be supplied:
- The IRS uses Form 4564, Information Document Request, to request software backup files (along with the administrator user name and password) from the taxpayer or representative.
- The file must be provided by DVD, CD or flash drive—and not by email. If the practitioner mails the storage media, the IRS recommends that the file be encrypted and the password be sent separately.
- The IRS will use the files to test the integrity and veracity of the accounting records—to test the business’s internal controls. This is always the first step for examiners, but they can do it more quickly and thoroughly using electronic records.
One tax forum participant asked how the IRS would proceed if a person other than the taxpayer or the representative had done the bookkeeping and refused to release the backup file as “proprietary” information. The IRS would summon the file, according to the IRS representative. The participant voiced concern that the IRS would have a copy of the file but the taxpayer would not—a situation the IRS representative characterized as a civil matter not involving the IRS.
As for reviewing the electronic files, the IRS representative echoed other IRS statements that the agent would review only data relevant to the years under audit, which could include data from other periods as long as they relate to the audit scope. The representative also said that the IRS examiner needs supervisor approval to expand the audit scope to additional years, and that the taxpayer would be notified in that case.
Some CPAs are optimistic that using electronic files could streamline the audit process. Other practitioners have experienced an IRS learning curve with their small business clients who have been audited.
REPRESENTING SMALL BUSINESS CLIENTS
Practitioners do not want to impede an examination and violate Circular 230, Section 10.20, by refusing to provide requested records to the IRS. However, practitioners have a duty to protect their clients by not providing more than what the IRS requests.
Here are some tips to protect clients from unnecessary inquiry and audit depth:
Keep audit trails on. Practitioners do not want the IRS to perceive that their client’s internal controls are weak. When the IRS requests records with associated audit trails, all of a taxpayer’s recording errors are exposed, and the agent can make conclusions based on entries that are reversed or corrected. Errors and corrections are common for many business owners who purchase programs such as QuickBooks to save on bookkeeping fees. If the IRS concludes that a taxpayer’s controls are weak, the IRS may expand the audit.
Some practitioners have suggested that their clients turn off the audit trail indicator on QuickBooks. Regardless of the reason, that approach is not advisable, because it will immediately raise the audit agent’s suspicion.
Keeping audit trails active also supports the IRS’ preference for contemporaneous recordkeeping. However, when there’s an error in an entry or account, the taxpayer or accountant should document several items: the erroneous entry, the correction and an explanation of the correction. The taxpayer should also include documentation to support the correction, especially for large and unusual items. When the IRS questions the corrected entries, the taxpayer can provide the documentation to demonstrate to the agent that he or she is an effective bookkeeper and that the records are trustworthy.
During tax preparation, create a new workpaper highlighting any large, unusual or frequently examined entries that have been corrected. Maintain the explanations in your client’s records to document your due diligence and reduce your risk.
Set limits, if possible. Be cautious when providing only the data for the year under audit by condensing transactions in nonaudit years. Discuss your concerns with the IRS agent or his or her manager before fulfilling the document request with the backup file. Explain in writing to the IRS exactly what you will be condensing. In the future, create separate backup files for each year. Be clear when responding to the IRS information document request about exactly what data you are providing and not providing.
You could also ask the IRS agent whether he or she will accept an alternative, such as printouts of accounts with detailed explanations. Before 2010, that was the method used in most SB/SE audits. Explain to the agent why it is a better approach; after all, it is how the return was prepared.
If your client has used QuickBooks utility programs such as QB or not QB to remove prior-year data, explain in writing to the agent exactly what was done when you provide the file. A word of caution: The IRS could view the use of these kinds of software products as the equivalent of not turning over the full software file. Warn your clients that providing less than the full file to the IRS might encourage the perception that they are attempting to hide something or have stripped out data that might be relevant to the audit.
If your client is a poor bookkeeper, request that he or she relinquish that duty to someone who is more qualified. You can encourage your client by explaining that the IRS may review every right or wrong keystroke in an audit. Encourage them to follow a good, old-fashioned cliché: “Measure the transaction twice, post the entry once.” This also makes the CPA year-end audit easier.
If possible, consider consolidating your client’s electronic systems into one complete system. Use of several systems confuses the IRS and adds complexity in an audit. Using one system to record revenue and another to record payables is confusing for everyone.
Be upfront with the IRS and your clients. Snow, the AICPA committee member, suggested that practitioners visit with the IRS group manager to discuss the need for the electronic files, and if your client is adamant about not turning over the complete files, meet with the territory manager. If your client authorizes providing the electronic files, Snow suggested noting the authorization in the engagement letter. “If you’re representing a client who does not want to turn software files over to the IRS, be sure you don’t violate Circular 230,” he said.
THE OUTLOOK FOR ELECTRONIC FILES IN IRS AUDITS
It appears the IRS is advocating restraint in how its agents examine electronic files. However, the IRS has been clear that it expects full access.
Practitioners should always exercise caution in representing their clients. As audits of small businesses continue to increase, practitioners will need to closely monitor entries on their clients’ books and records to protect them from unnecessary inquiry by IRS agents. Practitioners should also carefully observe how the IRS uses these files as agents become more comfortable using electronic records.
When it comes to electronic files in small business audits, practitioners can take advantage of the tips provided in this article and continue to use the best practices they already know: Balance risk, follow professional judgment and look to the IRS for updates and guidance.
Editor’s note: Portions of this article originally appeared in the July/August 2011 edition of the Tennessee CPA Journal and are reprinted with permission from the Tennessee Society of CPAs.
EXECUTIVE SUMMARY
Jim Buttonow (jbuttonow@newriverinnovation.com) is co-founder of tax technology company New River Innovation in Greensboro, N.C.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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